Fixed income: to be or not to be invested

For several years one question has been asked again and again – whether one should (still) be invested in global fixed income. The reasons to be cautious about the outlook for global bonds can be grouped into three main categories.

The first reason to worry is that global bond prices have been going up for a long time already, so at some point they must start to come down. It’s true that asset prices are unlikely to go up forever, but as can be seen in the chart below, the same conclusion could have been drawn five, ten or fifteen years ago.

What goes up must come down?

Having said that, the continued decline in global bond yields over the past few decades has been fascinating. One explanation for this decline in yields is a revival of the notion of ‘secular stagnation’, whereby the underlying problem is that the real interest rate that balances savings and investment at full employment may be substantially negative. In our view, this shift in savings/investment balances can to a large extent be attributed to demographics. Over the last few decades, the number of ‘prime savers’ (roughly between the ages of 25 and 65) as a percentage of the total population has increased steadily, resulting in high desired savings relative to investments. At this moment, however, the ‘prime savers’ population shift is largely over, suggesting the decline in global rates might be nearing its end.

A second reason to worry is that for fixed income, higher prices mean lower yields, and yields cannot drop below zero. At least, that is what we thought until recently. Currently, around 20% of the Euro government bond indices carries a negative yield. Early this year, this number was even close to 30%. Still, yields are very low, and at around 1.7% – the current yield on the Barclays Global Aggregate index – the upside for yields (or downside for prices) seems far higher than the reverse. There is some truth here, but one should remember how at the start of this century, Japanese 10-year yields at 1.8% were seen as ‘ridiculously’ low. In the next 15 years, Japanese 10-year yields rarely traded above 1.8%. With the benefit of hindsight, we all understand that economic fundamentals were justifying these low bond yield levels.

This brings us to the third reason: valuation. This seems the only correct way to assess the outlook for global fixed income. Unfortunately, it is also the most subjective one. Even without Quantitative Easing, models based on traditional inputs like economic growth, inflation and official policy rates are likely to come up with different fair values, depending on one’s views on these variables. Next to that, by how much should fair value yields be lowered because government bond supply minus central bank buying in the four major developed economies will be nearly flat in 2015, the smallest number since early this century?

Adding it all up, we only see modestly higher bond yields for the next six to twelve months. The long-term demographic trend is likely to turn from bond positive to bond negative, but this is a very gradual process, and not something that is going to push up bond yields sharply next year. Furthermore, we acknowledge that bond yields are very low, but that there are good reasons why the ‘low for longer’ environment can persist – massive bond buying by central banks being one of these reasons.

Finally a word on one of the main worries of the financial markets – Fed rate hikes. We like to stress that the impact of Fed rate hikes should not be over-estimated. For example, the Fed is likely to raise rates when the economy is doing well, which is a positive for corporate spreads. Assuming that US 2-year swap rates – a proxy for Fed fund expectations – will rise by 250 basis points in the next two years, the yield on the Barclays Global index is likely to go up by around 1.0%, based on historical relations. Including carry, this results in a total return of -1.0% per year. Bad, but not disastrous. Any bond fund with a more aggressive active return profile should be able to get the total return back into positive numbers.

ENDS

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